Potbelly - Too Rich Valuation For This Fast Casual Chain

Shares of Potbelly (NASDAQ:PBPB) continue to be in demand after reasonable third quarter earnings report. After a very successful public offering last month, I think shares are valued a bit too rich given the poor profit margins and low comparable store sales growth. I remain on the sidelines.

Third Quarter Results

Potbelly generated third quarter revenues of $78.0 million, up 11.7% on the year before. Growth has been driven by new store openings as Potbelly opened 8 new company-owned stores and one franchise store. Consensus estimates for revenues stood at $77.9 million.

Comparable store sales growth came in at 2.5% for the quarter.

Adjusted earnings rose by nearly 27% to $3.2 million, resulting in earnings per share of $0.15 per share. Analysts were looking for earnings of $0.09 per share.

CEO and Chairman Aylwin Lewis commented on the third quarter performance, "We are pleased with our third quarter results. This was our first quarter of reporting as a public company and it was important that we achieved the growth results in line with our long-term targets."

Outlook

Full year revenues for 2013 are seen between $300 and $303 million. Adjusted net earnings are seen between $7.5 and $8.1 million. The guidance implies that revenues are set to rise by 9.7% at the midpoint of the range.

For the full year of 2013, Potbelly aims to open 40 to new stores. Comparable store sales rates are seen in the low single digits, adjusted for the 53rd week holiday shift.

Valuation

Potbelly did not provide a balance sheet with its third quarter earnings report. The company noted that it received a $108.8 million in net proceeds following the public offering. It used these funds to pay a $49.9 million cash dividend and repay borrowings of $14 million.

Combined with the nearly $22 million in cash balances pre-IPO, this should result in a net cash balance of around $66 million.

Revenues for the first nine months of the year came in at $225.0 million, up 11.7% on the year before. Net earnings rose by 6.6% to $6.2 million, as earnings per share rose by a penny to $0.29 per share.

Factoring in gains of 13% on Wednesday, with shares exchanging hands at $30.50 per share, the market values Potbelly at $880 million. This values operating assets of the firm at some $815 million.

As such, operating assets are valued at 2.7 times annual revenues and roughly a 100 times adjusted net earnings.

Potbelly does not pay a dividend.

Some Historical Perspective

Shares of Potbelly were sold to the general public at the start of October. Shares quickly settled in their low-thirties but slipped to lows of $23 a week after the public offering. On the back of the third quarter earnings report, shares are currently trading just above the $30 mark.

Between 2009 and 2012, Potbelly has increased its annual revenues by a cumulative 28% to $275 million. The company turned losses into net earnings for 2011 and 2012.

Investment Thesis

Investors are very excited with the third quarter earnings report and I fail to see why. Revenue growth is mostly driven by new store openings, as comparable store sales amounted to only 2.5%, even though they accelerated compared to previous periods.

Combined with income from operations totaling just 4.1% of total revenues, it is evident that the company needs much more sales leverage to boost earnings meaningfully. Net profit margins are very low, even compared to some other "casual" food chains, while comparable store sales are relatively low for an emerging chain.

Given that an average Potbelly shop generates about a $1 million in annual sales, the company needs to open a lot more stores, or grow sales at existing stores faster to become a very meaningful player. Note that the company now owns and operates 288 stores, while it also operates 19 franchises in the US and the Middle East.

At the start of October, just days after its public offering, I last took a look at Potbelly's prospects. I urged investors to be cautious after shares have roughly tripled from the guided price range. Shares ended their opening day with gains of nearly 120% at levels equivalent to current trading levels.

While the valuation looks reasonable on price-sales terms, the lack of meaningful earnings are a red flag to me. On the back of slow comparable store sales growth and not too impressive revenue growth rates, I reiterate my cautious stance. The third quarter earnings report does not contain new information which makes me change my stance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.